Solution to Case 103

IF THE COAT FITS WEAR IT – TEACHING NOTE

Questions
1. Your supervisor, Vic Gonzales, has asked you to prepare a capital budgeting report indicating whether ISGC should replace the existing machine or not. Indicate how would you proceed (without making any calculations)?

I would estimate the incremental cash flows over the economic life of the new machine, taking into consideration the after-tax salvage values of the old and new machine respectively. Changes in net working capital would be figured in as well. For the terminal year, we would assume that the net working capital is recovered and treat it as a cash inflow.

2. Explain the relevance of incremental cash flows, sunk costs, and incidental costs in the …show more content…

9. After looking at the data provided by Vic, you realize that the revenue and cost figures have not been adjusted for inflation. If inflation were expected to be at least 3% per year, what effect would this have on your analysis? Adjust the data and recalculate the relevant cash flows.

If revenues and costs are adjusted upwards by the 3% inflation rate, the Net Present Value will typically increase and the IRR will get larger. It is imperative that either nominal cash flows (adjusted upwards for inflation) be discounted at the nominal discount rate (15%) or that the discount rate be adjusted downwards (into the real rate) and then used to calculate the NPV of the unadjusted cash flows.

10. What recommendation would you make to Vic regarding the replacement of the old coating machine? Explain.

Based on the calculations, the new machine has a positive net present value of (see the Spreadsheet solution), after the cash flows are adjusted for inflation. The IRR likewise is considerably more than the discount rate of 15%. This shows that the old machine should be replaced.

11. If the new machine has an economic life of 15 years while the current machine has a life of only 10 years, how would the capital budgeting analysis have to be adjusted? Please explain by performing the necessary calculations.

See Spreadsheet solution for the necessary